Last Updated 11 May 2021

Fixed Cost and Variable Cost

Category Salary, Variable Cost
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Fixed Cost and variable cost makes up the total cost of the business.  Fixed Cost is costs that do not change during a specified period.  They are expenses of the company that is not affected by the change in proportion to the activity of a business (Ross et.al, 1995) .  For example, the least payment on the production facility and the company president’s salary  are fixed cost.  But of course, fixed cost are not fixed forever.  They maybe only fixed, maybe let’s say for a quarter or a year.  Beyond that time, lease can be terminated and executives may retire.  More to the point, any fixed cost can be modified or eliminated given enough time, so in the long run all cost are variable.  Thou we should always remember that during the time that the cost is fixed, that cost is effectively a sunk cost because we are going to pay for it no matter what.

On the other hand, a variable cost is a cost that is directly proportional to the activity of the business.  It depends on the amount of good or services produced during a period of time.   Examples of this kind of cost are the labor, transportation and raw materials.

The main costs that a manufacturer faces can be summarized in the following table:

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  • Cost item
  • Cost category
  • Justification
  • Raw materials to be processed
  • Variable (proportionally)

Production recipe:

  • any un-proportional change would impact the features of the product
  • Semi-manufactured components to be assembled
  • Variable (proportionally)
  • Production recipe
  • Energy
  • Variable (less than proportionally)
  • Physical properties produce economies of scale
  • Personnel (direct labour)
  • Variable (proportionally)
  • Constant productivity of people directly involved in production
  • Particularly flexibility-oriented legal contracts with the labour force
  • Personnel (indirect labour)
  • Quasi-fixed

The size of necessary administrative personnel (and of other indirect labour) doesn't change so much if production incrementally changes. Discrete jump will happen when the overall scale of production drastically changes.

  • Plant rent
  • Fixed
  • The typical contract of rent makes no reference to effective production levels
  • Amortization of capital goods
  • Fixed
  • Fiscal and accountancy rules
  • Policy costs (advertising, R&D,...)
  • Fixed or quasi-fixed
  • Discretionary costs

The above-mentioned table is just a rough and conditional description. It is only meant for easy introduction to the problem - often implicitly assuming many specific hypotheses.

References

  1. Piana, Valentino (2003) Cost.  Economics Web Institute.  Viewed on: June 9, 2006.  Available at: http://www.economicswebinstitute.org/glossary/costs.htm#cost
  2. Ross, S.A., Westerfield, R.W., & Jordan, B.D (1995) Fundamentals of Corporate Accounting (3rd ed.). The Irwin Series in Finance. Chicago; Bogota; Boston; Buenos Aires; Caracas; London; Madrid; Mexico City; Sydney; Toronto.
Fixed Cost and Variable Cost essay

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